Support & Resistance Levels - Concepts

You'll often hear technical analysts talk on about the ongoing battle between the bulls and the bears, or the struggle between buyers (demand) and sellers (supply). This is revealed by the prices a security seldom moves above (resistance) or below (support) or can simply say as the band in which the said stock is expected to fluctuate during a trading session.

This article of mine is an attempt to explain the basic concepts of Support & Resistance levels and how they are calculated.

What are Support & Resistance levels?

Support and Resistance levels are exactly what their names imply.

Support is the price level through which a stock is not expected to fall. Resistance, on the other hand, is the price level that a stock is expected to surpass. To put this differently, the price level which, historically, a stock has had difficulty falling below. Thus this is a level at which a lot of buyers tend to enter the stock which in turn creates a demand for the stock and pushes the price of the stock up. This is often referred to as support level.

Resistance is a price level which a stock finds it difficult to break through. To put this differently, the price at which a stock or market can trade, but not exceed, for a certain period of time. The stock or market stops rising because sellers will increase more than the number of buyers which in turn will increase the supply in the market and thus pulls the price of the stock down. This is often referred to as resistance level.

Testing the support & resistance levels:

If the price of a stock falls towards a support level it is a test for the stock. The support will either be reconfirmed or wiped out. It will be reconfirmed if a lot of buyers move into the stock, causing it to rise and move upwards from the support level. It will be wiped out if buyers will not enter the stock and the stock falls below the support.

If the price of the stock rises towards the resistance level, it is a test for the stocks resistance. The resistance will either be reconfirmed or breached. It will be reconfirmed if lots ofsellers place sell orders at that level, causing the price of the stock to come down from the resistance level. It will be breached out if sellers will not enter the stock and the stock raises above the resistance.

Role Reversal

Once a resistance or support level is broken, its role is reversed. If the price falls below a support level, that level may become resistance. If the price rises above a resistance level, it may often become support. As the price moves past a level of support or resistance, it is thought that supply and demand has shifted, causing the breached level to reverse its role. For a true reversal to occur, however, it is important that the price make a strong move through either the support or resistance.

In almost every case, a stock will have both a level of support and a level of resistance and will trade in this range as it bounces between these levels.

Importance of support & resistance levels:

These support and resistance levels are seen as important in terms of market psychology and supply and demand. Support and resistance levels are the levels at which a lot of traders are willing to buy the stock (in the case of a support) or sell it (in the case of resistance). When these trend lines are broken, the supply and demand and the psychology behind the stock's movements is thought to have shifted, in which case new levels of support and resistance will likely be established.

Support and resistance analysis is an important part of trends because it can be used to make trading decisions and identify when a trend is reversing. For example, if a trader identifies an important level of resistance that has been tested several times but never broken, he or she may decide to take profits as the security moves toward this point because it is unlikely that it will move past this level.

Support and resistance levels both test and confirm trends and need to be monitored by anyone who uses technical analysis. As long as the price of the share remains between these levels of support and resistance, the trend is likely to continue.

It is important to note, however, that a break beyond a level of support or resistance does not always have to be a reversal. For example, if a price moves above the resistance levels of an upward trending channel, the trend has accelerated, not reversed. This means that the price appreciation is expected to be faster than it was in the channel.

Being aware of these important support and resistance points should affect the way that the trader trades a stock. Traders should avoid placing orders at these major points, as the area around them is usually marked by a lot of volatility. If the trader feels confident about making a trade near a support or resistance level, it is important that he/she follow this simple rule: do not place orders directly at the support or resistance level.

This is because in many cases, the price never actually reaches the whole number, but flirts with it instead.

So if you're bullish on a stock that is moving toward an important support level, do not place the trade at the support level. Instead, place it above the support level, but within a few points. On the other hand, if you are placing stops or short selling, set up your trade price at or below the level of support.

How to calculate support & resistance levels of stocks?

There are many ways to calculate levels of support and resistance (Pivot point method, Moving averages, Fibonacci numbers etc). One of the most common is to use a series of formulas to calculate "pivot points", described herein.  

·         Calculate the pivot point as follows, using the previous day’s high, low, and close:

Pivot or P = (High + Low + Close) / 3

·         Calculate the first support point               : S1 = (P x 2) – H

·         Calculate the second support point           : S2 = P - (High - Low)

·         Calculate the first resistance point           : R1 = (P x 2) – Low

·         Calculate the second resistance point       : R2 = P + (High - Low)

Adjusted Pivots

Many traders adjust their value for P as follows:

P = O + (H + L + C) / 4 (where H, L & C are from the previous day’s stock details) and O is Today's Opening Price.

Pivot points are short-term indicators, and ultimately it is the trader's responsibility to use them wisely, in conjunction with other confirming indicators. However, a set of pivot points must be recalculated each day.

Three principle factors determine the strength of support and resistance levels:

The longer the period of time a price trades in a specific area of support or resistance the greater the significance of the level.

Volume is another way to gauge the importance of a level- the more volume of trading that takes place the more significant the level. The more recent the activity the more significant the level- the reason being that the level is influenced by the positions of traders currently in the market.

Conclusion

Determining future levels of support can drastically improve the returns of a short-term investing strategy because it gives traders an accurate picture of what price levels should prop up the price of a given security in the event of a correction. Conversely, foreseeing a level of resistance can be advantageous because this is a price level that could potentially harm a long position because it signifies an area where investors have a high willingness to sell the security. As mentioned above, there are several different methods to choose when looking to identify support/resistance, but regardless of the method, the interpretation remains the same – it prevents the price of an underlying from moving in a certain direction.